THE MAKE OR BUY DECISION:
Mountain Goat cycles, the company is now producing the heavy
duty gear shifters used in most popular line of mountain bikes. The
company’s Accounting Department reports the following cost of pro
ducing 8,000 units of the shifter internally each year.
Exhibit 1
Direct Materials
Direct labor
Variable overhead
Supervisor’s salary
Depreciation of
equipment
Allocated gen overhead
TOTAL COST
Per unit
$6
4
1
3
2
8,000 units
$48,000
32,000
8,000
24,000
16,000
5
$21
40,000
$168,000
--
An outside supplier has offered to sell8,000 shifters a year to the
company at a price of $19 each. Should the company stop
producing the shifters internally and buy from outside supplier?
As always the focus of Management decision should be on the
RELEVANT COST-those that differs from the alternatives. And the
costs that differ between the alternatives consist of the costs
that can be AVOIDED by purchasing the shifters from outside
supplier. If the costs that can be avoided by purchasing the
shifters from outside supplier total less than $19, then the
company should continue its own shifters and reject the outside
supplier’s offer. On the other hand, if the costs that can be
avoided by purchasing the shifters from outside supplier total
more than $19, the outside supplier’s offer should be accepted
-
Note that depreciation of special equipment is listed as one of the costs of producing
the shifters internally. Because the equipment has already been purchased, this
depreciation is a SUNK COST and is therefore IRRELEVANT. If the equipment could be
sold, its SALVAGE VALUE would be RELEVANT. Or if the machine could be used to make
other products, this could be relevant as well.
Also note that the company is allocating a portion of its general overhead costs to the
shifters. Any portion of this general overhead cost that would actually be eliminated if
the gear shifters were purchased rather than made would be relevant in the analysis.
However, it is likely that the general overhead costs allocated to the gear shifters are in
fact common to all items produced in the factory and would continue unchanged even
if the shifters were purchased from outside supplier. Such allocated costs are not
relevant costs (because they do not differ between make or buy alternatives) and
should be eliminated from the analysis along with the sunk cost.
The variable cost producing the shifters can be avoided by buying the shifters from the
outside supplier so they are relevant cost. We will assume in this case model analysis
the variable costs include direct materials, direct labor and variable overhead. The
supervisor’s salary is also relevant if it could be avoided by buying the shifters.
Direct Materials (8,000 x $6 per unit)
Direct labor (8,000 x $4 per unit)
Variable overhead (8,000 units x $1 per
unit)
exhibit 2
Supervisor’s salary
Depreciation of special equipment (not
relevant)
Allocated general overhead (not
relevant)
Outside purchase price
Make
$48,000
32,000
8,000
Total Relevant
Costs-8,000 units
Buy
-
24,000
-
-
-
-
_______________
$152,000
_
Total Cost
$112,000
$152,000
Difference in favor of continuing to make
$40,000
-
Exhibit 2 contains the relevant costs analysis of the MAKE OR BUY
decision assuming that the supervisor’s salary can indeed be avoided.
Because it costs $40,000 less to make the shifters internally than to
buy them from the outside supplier, Mountain goat Cycles should
reject the outside supplier’s offer. However the company may wish to
consider one additional factor before coming to a final decision-the
opportunity cost of the space now being used to produce the shifter.
OPPORTUNITY COST- If the space now being used to produce the
shifters would be otherwise idle, then the company should continue to
produce its own shifters and the supplier’s offer should be rejected.
But if the space now being used to produce shifters could be used for
some other purpose? In that case the space would have an
OPPORTUNITY COST equal to segment margin that could be derived
from the best alternative use of the space.
-
To illustrate, assume that the space now being used to produce shifters
could be used to produce a new cross-country bike that would generate
a SEGMENT MARGIN OF $60,000 per year. Under this condition the
company should accept the supplier’s offer and use the available space
to produce the new product line:
Exhibit 3
Total Annual Cost (see exhibit 2)
Opportunity cost-segment margin forgone
on potential new product line
Total cost
Difference in favor of purchasing from
outside supplier
MAKE
$112,000
BUY
$152,000
60,000
$172,000
$152,000
$20,000
The OPPORUNITY COST for Mountain Goat Cycles is sufficiently large in
this case to change the decision.